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With that said lets look at the macro backdrop and my thoughts on positioning.
Financial Conditions
With all the Fed interest rate hikes topping 5.00% now and ongoing QT of $95Trillion per month ($60Trillion T-Bills and $35k MBS products) there really isn’t too much tightening of financial conditions to be honest.
The landscape isn’t accommodative in the belly of the chart below but it isn’t like the VAR shock 0.5 level at peak Covid/Financial Crisis. That being said leverage is certainly low but risk appetite and credit are at moderate levels, i.e. investors are in the market but perhaps are more cautious and not applying as much leverage as they may have done in the past.
When in doubt, ZOOM OUT……….. We aren’t in terrible shape. Should a “hard landing” occur and conditions spike positive (i.e. above 0.0), history tells us that there will be interventions, but with the lower levels of leverage its hard to see how extensive a VAR shock could be.
Central Bank Balance Sheets
The US Regional Banking crisis of March/April (and now May) 2023 created a systematic flow of temporary credit via Discount Windows and the new Bank Term Funding Program (“BTFP”). The debate as to whether this injection of liquidity was in fact QE remains a mute point as liquidity is liquidity after all.
The Central Banks have been reducing their Balance Sheets to be fair, but it isn’t lost on me that in the slightest crisis (Credit Suisse or US Regional Banking) the balance sheets started to tick upwards if only temporarily. It makes me believe that while these levels will reduce they will be matched by Fiscal Liquidity via Fiscal Spending and in the event of another crisis these balances will raise as a Buyer of Last Resort for Sovereign Debt.
US Inflation Core PCE, CPI & PPI Prints
While Core PCE won’t be printed for April until late May, the chart below shows a levelling trend and that costs have stagnated to a recurring rate of change level.
On the CPI we are seeing a similar but steeper leveling off but we have reached the 5.0% level and stayed there or there abouts for two consecutive months.
One could take comfort in the fact that the Fed have finally outpaced US CPI compared with the Fed Funds Rate 4.9% v 5.25%. Job done???
The Producers Price Index (PPI) does tend to lead the inflationary / disinflationary cycles and perhaps markets have felt relief that the rate of change YoY have dropped dramatically from peak summer 2022. In essence, with production costs now at a lower rate of change we should expect CPI to reduce further.
However, if there will be a “credit crunch” or easing of credit flows due to the collapse / consolidation of the US Regional Banking sector we may see reduced production as capacity is lowered
Fed Funds Rate
The Fed increased its Fed Funds Rate by 25bps from 4.75%-5.00% to 5.00%-5.25% on May 3rd FOMC.
US Bond Market
The 4Wk or 1Month Treasury Bill is pricing in a possible last 25bps hike at 5.7%. How easily we forget that the same duration T-bill was trading as low as 3.35% no longer than April 23rd.
There does appear to have been a huge demand for very short term treasuries towards the end of April as Balance Sheets were reinforced with pristine collateral to mitigate some other unknown factors.
With the trial plough into the 4Wk Treasury we have been given a taste of what a bull steepener would look like as the front end of the curve flattens at much faster rate than the long end, signaling a possible Interest Rate Cut and likely Recession.
Liquidity
China did create a lot of liquidity into the global system for their Re-Opening post Pandemic in the early part of the year. Short Term Indicators do show a pause in those funding flows but also a massive, record even Chinese Current Account balance up to M4 of 2023.
The chart below courtesy of Cross Border Capital highlights a wider view on liquidity and how we find ourselves beyond the Global Liquidity lows and are ticking upwards. These cycles take years to play out and there will always be volatility in markets, but this trend along with the pending introduction of New US Treasury Collateral (post a lifting of the US Debt Ceiling) should provide ample securities to move liquidity by increasing the velocity of stagnant capital.
Reverse Repo (“RRP”)
While not at peak levels it shouldn’t be missed that RRP rose greatly while liquidity market reduced. This money parked overnight at 5.08% in my view has simply has had nothing to buy that was better than the Fed Funds Rate with overnight access.
The spikes do come at quarter ends (see $2.5 Trillion reached in Dec 31st 2022) but there is a small uptick in the overnight balance. As this account drains, which I believe it will as the US Debt Ceiling is lifted and almost $2.0 Trillion of new Treasuries hit the market in the next 12 months we will see liquidity back in the market and a rise in that Global Liquidity chart from Cross Border Capital.
Conclusion
I am quietly bullish here with 65% risk on / 35% risk off no leverage. I am expecting a retracement and I am mindful of a potential rate cut into recessionary pressures, but with Unemployment at 3.4% and GDP low it would have to be a credit crunch that collapsed the economy with the market most likely forecasting that 3-6 months before hand.
For credit crunch terms and banking collapses I feel recent actions can be repeated to the point that it mitigates a banking collapse. In terms of an outright credit crunch, I’m certainly seeing in the Corporate Finance sector as competition for deals is lower and terms are tightening. It just might mean that M&A activity is lower.
However, I’m not seeing an orderly sell off or flash bear market rallies, I’m starting to see investors climb the wall of worry (without a huge amount of leverage). Once leverage is applied things could move fast very quickly.
Some forecasters think that there is a 50% of a Fed rate cut by July 26th FOMC. I genuinely believe that inflation will remain sticky between 3.75% and 4.75% for a while, allowing the Fed to pause and stay higher for longer.
I’m having trouble with Value Stocks due to the increased discounted cost of capital which their discounted cash flows rely on, particularly if M&A activity and leverage is reduced. I am focused on the Growth Stocks/Emerging Tech supported by Long Gold and Short ‘long duration’ Bonds (TLT).
NB: This is not financial advice and you should contact your own independent financial advisor before putting any of your money into these volatile markets.
Isn't increased discounted cost of capital even more problematical for Growth Stocks/Emerging Tech ?
having trouble with Value Stocks due to the increased discounted cost of capital which their discounted cash flows rely on, particularly if M&A activity and leverage is reduced. I am focused on the Growth Stocks/Emerging Tech supported by Long Gold and Short ‘long duration’ Bonds (TLT).